Five People You Meet In The Millionaire’s Club

The latest salvo from the White House in their quest to “create jobs” and “reduce the deficit” (they aren’t proving particularly good at either one, hence the quotes), is this idea called the “Buffett Rule” or the “Millionaire’s Tax”. The idea is simple: All these people who make a million or more per year don’t need all that money, and won’t miss it if we take a little more of it, and all of that money will be put to good use by our uber-efficient federal government. So we’ll just raise the top income tax rate and get more money.

Ummm…no.

For now, let’s not worry about what would happen to the money once it gets in government’s hands, because that actually isn’t the issue here. The question is: Is this actually going to result in more tax revenue coming into the government in the first place?

In examining this, we have to keep one thing in mind: Not all millionaires are alike. The people that would be affected by the “Buffett Rule” can generally be grouped into five different categories, although there is much crossover from one to another. Let’s go down the list…

1) Small Business Owners

Small business owners often file as a “Subchapter S Corporation” which allows the owner to pay the company’s taxes as though the business were an individual and the business’s profits were its income. This allows them to pay less than if they had to pay at the corporate tax rate. Generally speaking, a small business’s profits aren’t just going into the owner’s pockets, though; that money is used to either grow or sustain the business into the future.

So what happens if we raise taxes on them? Well, businesses that want to use profits to grow won’t be able to grow as much, and businesses that use their profits to sustain won’t be able to sustain as much. The latter results in reductions in employee benefits or reductions in employees, and in some cases, businesses go under altogether. It also increases the risk involved in starting a business, which may prevent some from starting to begin with. These things result in less competition, which is bad for the consumer.

Basically, any good you get out of more taxes from these companies is offset by the lack of taxes you’ll get from the laid-off employees and no-longer-existing businesses. And you can forget about more jobs or economic growth. So that’s one strike against the “Buffett Rule”.

Most people who make large amounts of money per year don’t live a “playboy” sort of lifestyle. Most of the time, those who earn large amounts of money put aside what they don’t need for later, and when they do so, they want to keep that amount of money as large as possible.

When the concept of “tax shelters” come up, these are generally derided as “loopholes” that rich people use to keep from “paying their fair share” of taxes. This isn’t quite true, however. Pre-tax investments and “tax shelters” don’t mean that the person doesn’t pay taxes on their income; it only means that they don’t do so right now. A 401(k) is a pre-tax investment: you haven’t paid taxes on it when you make the investment, but you also don’t have immediate access to that money. When you withdraw that money, it is then subject to income tax at whatever the rate is then. Other pre-tax investments work the same way. The investor is betting that at some point in the future, tax rates will be lower than they are now, which will save them money. It also has the benefit of giving them more money at the start, which as anyone who understands the concept of “compound interest” knows, will result in a bigger number at the end.

So what effect would the “Buffett Rule” have here? The people who have no choice but to withdraw money from their investments at this point, i.e. retired seniors, might have to pay more, but most of them aren’t going to withdraw enough to have this rate change apply to them. For the rest, it just means more people using these methods to defer payment of taxes until such a time as the rates are lower or they simply don’t have a choice. In other words, you’re not going to gain much of anything from this group, either. Strike two.

3) The Investor Class

This is the group of people that includes Warren Buffett himself, and I should take a moment to shoot down his anecdotal defense of this plan.

Buffett notes that since most of his “income” comes from capital gains (which are taxed at 15%), and he pays himself $100,000 per year from his investments (taxed at the top marginal rate of 36%), the end result is that his “effective tax rate” is less than that of his secretary.

Here’s the problem with that argument (and why I use the word “income” in quotations above): You can’t spend capital gains. An increase in your net worth does not translate to income until you sell a position and convert it to cash…at which point you are subject to income tax on any earnings. If he converted that net worth to cash, he most certainly would be paying a higher tax rate than his secretary would, though he’d be too busy swimming in a pool full of cash to care. It’s also worth noting that any stocks or funds that we buy on the market are generally bought with money that we’ve already paid income taxes on.

On top of that, his anecdote seems to suggest that he thinks the capital gains rate should be increased, which isn’t what is being proposed. An increase in the top income tax rate wouldn’t really affect him much, since he could always give himself a raise to cover for it. Most people don’t have those sorts of options, of course.

So why exactly is the capital gains rate lower than the income tax rate? Two reasons:

1) The capital gains tax is really an “intermediate tax” – as noted earlier, you still pay income tax on any earnings once the position is sold. This just gives the government some income in the meantime, since many people hold positions for years or decades.

2) It is kept lower to give people incentive to take risk and invest in the first place. As most amateur stock traders can tell you, investing involves risk, and more often than not, you end up losing instead of winning. If the risk is not worth the potential reward, there’s less reason to take the risk. (As both a former amateur – very amateur – stock trader and someone with a math degree and an emphasis in probability, I can back this assertion up.)

So raising the capital gains rate would only stifle investing, which runs counter to the whole idea of trying to create jobs. Then again, that’s not what is being proposed by the White House.

The actual proposal, as noted, would have practically no impact on someone like Buffett at all. You’d get a bit more from the $100,000 he pays himself, but you’re not getting any more of his capital gains unless he sells them (and why would he?). What it would do is keep people from selling or moving stocks unless they had to, because those transactions (if they resulted in gains) would get taxed at a higher rate. Again, this isn’t going to help economic growth any. The likely result is that many of these people will transition themselves to some degree into group two, which as we’ve noted, simply means less tax revenue being paid now.

4) The “Someone Else Pays Me” Group

Generally speaking, most of the people that are earning a million dollars per year or more are doing so either by investing or running their own businesses, and are thus profiting from the growth they are creating. There are very few people who are actually paid a million dollars or more per year by someone else simply for performing a particular service, but there are a few: professional athletes, Hollywood actors, and a few in the higher levels of large companies are some examples.

For the most part, the latter group are people who understand business well enough to know what to do with that money once they earn it, i.e. they join groups two or three. Most of the others also have some sort of financial advisors or agents helping them figure out what to do with their money (which again means they join groups two or three), but there are a few who actually act exactly like liberals seem to expect every millionaire to act: they don’t pay any attention to what is happening to their money and just pay the higher tax rate, thinking that they’ll always get more. These are the people living the “playboy” lifestyle that was mentioned earlier. Often times, these are the people you see in documentaries on “E!” ten years after their fame has dried up, where we learn about how they squandered their wealth and are broke now. (And if drugs were involved – which they often are — you can bet that the dealers weren’t paying sales or income taxes on those transactions, either.)

All speculation aside, the “Buffett Rule” would have the intended effect on these people, but they are few and far between, because as noted, the smarter members of this set put themselves in groups two or three.

5) The “How Did I Get So Lucky?” Group

These are people whose income is insignificant next to their wealth, which they generally came into through no effort of their own. Either they inherit it (like Mark Dayton or any Kennedy at random), or they marry into it (like John Kerry). These people often end up being liberal politicians or activists, sometimes because they don’t know how the money was made in the first place, and sometimes because they feel guilty that they got so lucky and like to assume or pretend that every other rich person got lucky, too.

Most of the time, these people are also in groups two and three, but they need to have their own group to highlight them, because these are often the people who have some say in what the tax rates actually are. More to the point, it needs to be highlighted that these people could honestly not care less about what the tax rate is, because it doesn’t affect them a bit. Even if they weren’t putting their income in places where it is sheltered from the current tax rate, it wouldn’t matter if you taxed their income at 100%, because they can (and do) simply live off of accumulated wealth. So it’s very easy for people like this to talk about how they would have no problem paying a little bit more, because it’s not like their income actually matters to them. The problem is that it matters to a lot of other people. Again, though, most of these people shelter their income by other means, which makes their posturing even more hypocritical, although it helps them politically.

So out of these five groups, we have the first three who you aren’t going to get a net gain from, and two others which are smaller than they appear, since the smarter members of those groups cross over into the other groups.

So what good would the “Buffett Rule” do? Well, it would make some liberals feel better. That’s about all, though.